The Week in Public Finance: For an Increasing Number of Governments, One Credit Rating Is Plenty
A decade ago, most sought two or three ratings before selling their bonds. Not anymore.
For years, governments paid for the extra cost of getting multiple credit ratings when they sold bonds, mainly to appease the investors who bought them. But now, more and more governments are forgoing multiple ratings in favor of just one -- and 2018 is shaping up to be the biggest year yet for the trend.
Through the first five months of this year, 25 percent of bond sales have involved just one credit rating, according to data analyzed by the research firm Municipal Market Analytics. That’s far higher than the 13 percent rate a decade ago and the 20 percent average over the past few years.
Lisa Washburn, a managing partner at Municipal Market Analytics, says she expects the trend to continue, especially since issuances with just one rating don’t appear to be penalized with higher interest rates.
Source: Municipal Market Analytics
Seeking more than one rating has its risks. It increases the cost of issuance for a government to go to market and it raises the possibility that agencies will assign two different ratings, potentially increasing the interest rate a government would have to pay on the debt.
But until recently, research had found that it was generally worth it: Investors valued a second rating, and bond issues with two identical ratings typically got more favorable rates for governments than bond issuances with only one rating.
So what’s changed?
For starters, most governments don’t use bond insurance -- which used to account for more than half of bond sales -- anymore. Bond insurance allows a government to pay a AAA-rated insurer to guarantee the bond. This, in turn, essentially gave the sale a AAA rating. The bond insurance package also made it easier to obtain multiple ratings because governments didn't have to solicit ratings on their own.
With the downfall of most bond insurance companies following the financial crisis, governments now have to do the legwork themselves. And the more ratings they solicit, the higher the cost. Getting just one rating can run a government between $7,500 and $495,000 per municipal bond offering based on factors like the sector, amount financed, structure and complexity, according to research by Marc Joffe, a senior policy analyst for the Reason Foundation and Governing contributor.
Meanwhile, the process itself has become more transparent. Governments provide their financials online now and are increasingly hosting investor conferences to build relationships. New rules have also made it easier to find and compare a government’s hidden costs, like foregone tax revenue, and liabilities, such as pension debt.
“People have gotten much more comfortable buying asset-backed securities in the last few years,” says Joffe. “With the financial crisis well in the rearview mirror, I don’t think people are really that worried anymore.”
On the surface, this one-rating shift is a cost-saver for governments. Washburn notes that “curtailing costs related to borrowing is even more important in the current environment,” because for most governments the growth in expenses is outpacing revenue growth. But, she warns, “fewer constraints on borrowing reduces fiscal discipline and may encourage ill-advised borrowings for deficits, pensions, [retiree health care] and riskier economic development projects.”
Ksenia Koban, vice president and municipal strategist at the Los Angeles-area investment firm Payden & Rygel, disagrees with that assessment. She says that many firms have beefed up their municipal desks over the past decade and conduct their own independent analysis of each bond sale. Therefore, they should have considered and priced in any risks outside of what a credit rating agency assesses.
“You have all the tools -- you shouldn’t only be relying on ratings,” she says. “In the market, it’s buyer beware today more than we’ve ever had it.”
In other public finance news:
Illinois Budget Is More of the Same
Illinois has passed its first on-time budget in four years. Unfortunately, it largely relies on the money shuffling and revenue tricks that landed the state in financial trouble in the first place. While the $38.5 billion budget balances on paper, it leaves no financial cushion and relies on more than $1 billion in one-time funds.
On the pension side, the budget employs a complicated maneuver aimed at reducing the state’s immediate pension costs. Illinois will borrow $1 billion to afford a nominal pension buyout for some of its retirees. The optional program would reduce the cost-of-living raises these pensioners are in line to receive in exchange for an upfront payout.
In an analysis of the budget, S&P panned the strategy, noting it simply creates short-term savings while lawmakers avoid making tougher choices to reduce long-term costs. Add in the fact that the state borrowed $6 billion to pay off a little less than half of its unpaid bill backlog, and the agency says the state’s “precariously balanced operating budget,” liabilities and lack of budget reserve will continue to weigh on Illinois’ barely investment-grade credit rating.
Pension Costs Threaten Teacher Salaries
After several teacher protests and walkouts over low education funding, many expect the pressure to continue in states that have yet to restore funding to pre-recession levels. But Moody’s Investors Service warns that increasing funding doesn’t mean that all that money will go toward current students and teachers. State K-12 spending has shifted more towards employee benefits and away from salaries and wages in recent years, which has muted growth in teacher salaries, according to Moody’s Analyst Pisei Chea.
In 2005, 61 percent of total education spending went toward salaries and wages while 19 percent went to employee benefits. In 2016, salaries and wages declined to a 57 percent share while employee benefits increased to 23 percent thanks to increased pension payments. “As pension costs continue to grow,” Chea said in a statement, “it will be more difficult for states to maintain healthy growth of teacher salaries.”
To read this regularly, subscribe to "The Week in Public Finance" newsletter for free.